Five lessons from the financial crisis

Published on, by Finfacts Team, Sept 10, 2009.

Five key lessons stand out from the current financial crisis for both developed and emerging economies, according to Richard Berner, a managing director and co-head of Global Economics at US investment bank Morgan Stanley.

Looking ahead, he says each carries with it a key challen:

  • (1) A strong and well-regulated financial system should be the first line of defense against financial shocks.  The challenge is to ensure stability without stifling innovation and growth.
  • (2) Aggressive and persistent policy responses are the second line of defense for financial crises. The challenge is to time exit strategies to accommodate recovery.
  • (3) Macroprudential supervision and asset prices should both play bigger roles in monetary policy.  The challenges are to define systemic risk regulation carefully, to define boundaries between monetary and fiscal policy, and to balance financial stability with traditional goals.
  • (4) Flexible exchange rates enhance the ability of monetary policy to respond to shocks. The challenge is to embrace structural reforms and to build up financial strength and credibility to weather storms.
  • (5) Global imbalances contributed to the crisis by allowing internal imbalances to grow. The challenge is to resolve them in a way that will promote a vigorous and durable recovery.

A strong and well-regulated financial system: Richard Berner says it is a paradox that the more free market-oriented we want our economies to be, the more we need official supervision and oversight of our financial institutions and markets. That’s because truly free market economies involve a high risk of business failure, and corresponding high risks to the financial institutions and investors that lend to and invest in those businesses.  A key lesson from this crisis is that competition among lenders breeds innovation, but also instability …

… Won’t China and other currency interveners buy US debt as they seek to prevent appreciation?  Yes, but there are several worrying signs. First, private capital inflows peaked in 2006 and remain weak. Second, Chinese and other officials are becoming vocal about the perils of relying on the dollar as the sole reserve currency, so support from official inflows is also waning. Third, Chinese and Russian officials have maintained a near-record (26%) share of their holdings of US Treasuries in short maturities, exposing the US to considerable rollover risk. Moreover, the Morgan Stanley economist says it’s hard to imagine China buying more Treasury debt when China’s rebounding economy is absorbing domestic saving. Nor will an adjustment scenario involving slower US demand and Chinese export growth necessarily be benign. Authorities in that case will probably tolerate abundant liquidity and rising asset prices. The resulting decline in risk-aversion probably won’t be good either for the dollar or for US Treasuries.

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P.S.: The members of the G-20 are the 19 countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the UK and the US, as well as the European Union, represented by the rotating council presidency.

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